In May 2012, the Mongolian parliament
passed a law requiring parliamentary approval for foreign investors to take a
stake larger than 49% in enterprises in strategic sectors such as mining or for
investments by state-owned enterprises

And it was successful: The conditions imposed by the law created an
untenable level of uncertainty and on Chalco abandoned its bid on Tuesday

Mongolia’s fear of China is understandable, but the Mongolian government is
making a strategic misstep by in effect categorically rejecting Chinese
investment in its mining sector. It can discriminate against Chinese investors,
but it cannot change the fact that Mongolia is landlocked and cannot export
sufficient mineral volumes via Russian routes to break its dependence on China.

By excluding Chinese direct investments in mines, Mongolia simply trades one
form of influence for another. This is because even if coal and copper are
mined by American, Australian, Canadian or Mongolian firms, the minerals will
naturally flow to China—and in many cases move via Chinese-owned marketing
firms such as Winsway, which is now partially-owned by Chalco. If Ulan Bator
moves to curtail mineral flows to China, it will simply be embargoing itself.

What are the factors driving Mongolia’s dependence on the Chinese mineral
market?

The most obvious, and most important, is geography. Mongolia is far from the
ocean and high transport costs render most of its mineral production
uncompetitive in the international export market if exported through routes
other than China. Russia’s Pacific Ports are more than 4,000 km from coal and
copper deposits in the Southern Gobi desert, while the Chinese border is less
than 300 km from these reserves — and only 40 km in the case of the giant Ovoot
Tolgoi coal project.

Even for coal from Northern Mongolia, the combined transport cost and port
fees for shipment through a Russian Pacific Coast port can exceed US$100 per
tonne, which renders thermal coal sales cost-prohibitive and makes coking coal
uncompetitive against coals from Australia and other seaborne suppliers to the
East Asian market.

Another factor is Mongolia’s status as the low-cost supplier for many
commodities China needs. Mongolia already exports coal to China, which took 99%
of Mongolian coking coal exports in 2011, according to local sources. The country’s
mines are also poised to export copper, gold, and fluorite, and—further in the
future—electricity, uranium, and possibly potash and oil.

A slowdown that depresses global commodity prices will make Mongolian
commodities even more price-competitive in the Chinese market because Mongolian
mines tend to be low-cost producers and because they do not have to ship long
distances to reach the Chinese market. Australian coal and Chilean copper must
traverse thousands of km to reach China, while Mongolian coal and copper can
move as little as 40km and be in China.

In addition, Mongolian producers are likely to receive increasingly
favorable pricing for coal they sell into China because the production costs of
miners in Shanxi—the heart of China’s domestic coking coal production and much
of its thermal coal output as well—have been rising quickly in recent years.
For instance, data from Yanzhou Coal, one of China’s major underground miners,
shows that the cost of goods sold (which broadly reflects production costs)
rose by 32% between 2008 and 2011 at its Shanxi subsidiary and continues to
rise in 2012.

Finally, Russia has no economic interest in becoming a transit route for
competing Mongolian mineral exports. Unlike China, Russia does not actually
need the coal and copper Mongolia wants to move to market. Indeed, Russia is an
exporter of most of the minerals Mongolia is, or will be, exporting.

Russian miners do not want competition from Mongolian minerals. For
instance, steadily declining coal consumption in Russia and Europe has
reoriented Russian coal producers toward the Asian market and filled the
Siberian rail lines and Far Eastern coal ports almost to capacity. Politically
well-connected Russian coal exporters like SUEK and Mechel will fight hard, and
most likely successfully, to keep large volumes of Mongolian coal off Russian
rail lines and out of their Pacific Coast export terminals.

With seven major coal projects in Siberia and the Russian Far East aiming to
bring as much as 80 million tpy of coal production capacity online by 2020 and
Russia’s Pacific coal export terminal capacity likely to grow by less than 30
million tpy, severe capacity constraints will remain and Mongolian coal miners
wanting to use Russian routes will either be left in the cold or forced to
accept cut-rate prices even lower than those offered by Chinese traders.

On the company-level, a handful of firms may be able to bypass China and use
Russian routes to reach the seaborne market. For instance, in the coal sector,
an Australian-listed miner with deposits in Northern Mongolia, tells us that it
believes it can secure rail and port capacity to market some production through
Russia. But even if true in practice, this will be the exception that proves
the rule. On the national level (and likely on the company level for any
producer wishing to move more than a few million tonnes per year), Russian
rails and ports are likely to prove an inhospitable place for Mongolian mineral
exports.

Mongolian politicians and portions of the voting public support resource
nationalist policies in a large part out of fear that Chinese traders are
exploiting the country’s isolation and forcing Mongolian miners to sell at
unfair prices. The politicians’ statements and actions imply that they can
secure better prices. Yet resource nationalism—particularly for a country that
presently has relatively little leverage vis-à-vis China and cannot develop its
minerals independently—typically proves a self-defeating path that leaves the
populace worse off and angry for the wear.

The paradoxical reality is that continued resource nationalism will blunt
Western mining companies’ desire to invest in Mongolia and make Chinese capital
the “funds of last resort.” Ulan Bator’s antagonistic stance toward China is
also counterproductive because it could help foreclose the opportunity for
Mongolia to export resources via Chinese ports. Chinese ports are the only
route through which Mongolian resources such as coal could reach international
markets at a low-enough cost to remain price competitive.

Ultimately, China appears to seek secure, well-priced mineral supplies from
Mongolia, not a re-enactment of the Qing Dynasty period of political
domination. If Ulan Bator can establish political and regulatory stability and
create a fair investment regime that leaves space for Chinese capital, Chinese
consumers will be able to absorb the large volumes of Mongolian mineral exports
they need at prices sufficient to propel robust economic growth for years to
come.

Source : The
Wall Street journal